the Mideast, the Saudis, and our markets

First, I’ve been pretty quiet on the mideast goings ons.
I’ve been watching intently from the time Egypt made headlines,
and have yet to see anything of particular consequence to us, beyond oil prices.

I’ve yet to come up with any channel to world aggregate demand, inflation, etc. apart from oil prices.

Seems all moves in stocks and bonds have been linked directly or indirectly only to actual and potential changes in crude oil and product prices.

And the mainstream has yet to realize that ultimately the Saudis- the only producer with excess capacity, continues as price setter, at least until their excess capacity is gone.

So the price of crude oil remains set by decree, and not market forces.
And markets don’t yet seem to know that.
Credit the Saudis for outsmarting the world on that score.
They say they don’t set prices, but let the market set price, as they only set spreads to benchmark market prices they post for their refiners.
The world completely misses the simple difference between the Saudi’s reaction function as a price setter, and prices set competitively in the market place.

That’s like the Fed saying they don’t set $US interest rates, because they have a reaction function that guides them.

So what does that mean?

It means the price of crude will come down only if the Saudis want it to come down (assuming they do have excess capacity).

And my best guess is that their survival strategy includes a lower price of oil.

They will play the maestro with grand gesture and international ‘faux diplomacy’ with ‘high level’ behind the scenes goings ons with pledges to come to the rescue with promises of production increases to replace any lost output due to the crisis, making it clear that they are going the extra mile and taking extraordinary measures to ensure the western economies both won’t see any supply disruptions and prices will be contained. Making it clear that we owe them for their selfless, gargantuan, efforts and expenditures of political capital on our behalf.

It’s all a big show to ingratiate themselves to the West in the hopes of getting the western support needed to sustain their position of power.

And the west will never realize that prices went up only because the Saudis raised their posted prices under cover of their reaction function that the west mistakes for ‘market forces,’ and that prices will go down only as the Saudis simply lower their posted prices, as they continue to play us for complete fools.

Much like China does to us because we think we need to sell our Tsy secs to fund our federal spending.

And with lower crude prices we go ‘risk off’ and much of the recent moves in other markets reverse.

The other possibility is that the Saudis don’t cut price, maybe because they decide they want the increased revenues to sustain control domestically with increased distributions to their population.

One way or another, it’s all their political decision, and we don’t even understand how it works, which reduces the odds that whatever influence we might have will be used to our ultimate benefit.

Before the early 1970’s the price of oil was set by the Texas Railroad Commission, who kept it relatively low and stable, fueling growth with reasonable price stability, while govt policy fostered relatively high levels of employment and low output gaps.

Since the hand off to the Saudis in the early 1970’s, when circumstances allowed them to take over as swing producer/price setter, prices have increased dramatically with very high levels of volatility, disrupting the world order and fostering today’s very high levels of unemployment and massive output gaps, as govts struggle with fears of inflation and seemingly no understanding of the process that’s got us into that mess.

And now with the world turmoil perhaps largely a function of mass unemployment, and govts with no idea how to keep that from happening, the pendulum is shifting from order to chaos.

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31 Responses to the Mideast, the Saudis, and our markets

  1. Mario says:

    I love this article and these thoughts. So what do you think would solve this problem Warren? Can we get rid of price setters in oil all together whether its the TX railroad comm or Saudis or whoever? Can’t prices just float or is that my innocence getting the better of me? Don’t other commodities like wheat and softs, etc. all find their value without price setters? Why can’t oil be that way too?

    Does it just come back to supply dominance in the market? If so then how did the power shift so easily from TX to Saudis in the 70’s as you say? Did supply shift that quickly and drastically as well back then?

    Or are we all just simply destined to merely hope for a “benevolent monoplist” with oil as well as with our own capital (through the Fed)?

    Thanks again and Cheers!



    power shifted when demand increased, we went to full production, and became dependent on the new, foreign monopolist/swing producer

    it’s about being dependent on a foreign monopolist


  2. kogdato says:

    i think US and Europe should use their oil reserves immediately. Overwhise it would be too late and economies will got a great damage. Or, monetary authorities such as FED and ECB will make policy mistake, will hike rates (“to fight inflation”). Such move will reduce overall economic activity and result is new recession. But it doesn’t affect oil prices at all, so it will be stagflation.

    sorry for my awful english, i am from russia.


  3. mario says:

    Warren this is one of the best articles I’ve ever read on oil in the world.

    Wow. thank you and GREAT JOB here. Maybe we can get this posted on Forbes or Bloomberg or something eh?!?! Seriously great stuff Warren.

    Cheers mate.



    thanks, and go for it!


  4. Anas Jalil says:

    Paul Stevens , Energy Economics Prof at my research center wrote this in 2007;
    Two recent oil price trends which carry policy implications are developed in this section – The Asian Premium and the rise in oil prices since 1999.

    The Asian Premium is the observed difference between the price of crude oil sold into Asia compared to the other two main consuming areas – the United States and Europe. Since 1997, the formula prices of Arabian Light into Asia have averaged a premium of $1-1.50 per barrel while formulae prices to Europe and the USA have remained roughly similar.

    The Premium owe its origin to the aftermath of the 1986 price collapse.

    The Saudi formula prices (at least notionally) were determined in the market place and were based on various spot prices. Three pricing areas were introduced: deliveries to the USA based upon WTI: deliveries to Europe based upon Brent: and deliveries to Asia based upon an average of Dubai and Omani crude. However for each formula price ‘adjustment factors’ were applied involving ‘a little monthly ad hoc finagling, the details of which are not published and not generally known’. THE SIGNIFICANCE OF THIS PRICE-SETTING PROCESS IS THAT OTHER OPEC PRICES TEND TO ‘PRETTY MUCH FOLLOW’ THESE SAUDI FORMULAE PRICES.

    The Asian Premium is understood by reference to ‘DISCRIMINATING MONOPOLY’ and ‘limit pricing’. As part of the introduction of formula pricing, Saudi Aramco imposed destination clauses on crude sales and refused to allow spot sales. This was the key mechanism to keep markets physically separate. Without destination clauses, the Asian ‘limit price’ would be the European Price plus any additional transport cost. Most of the other Middle East crude suppliers have limited ability to sell more crude into Asia They are limited by the amount of crude they can shift from Europe to Asia in response to price differentials. By contrast Saudi Arabia with its very large excess capacity, can easily meet additional demand from Asia, albeit within the context of OPEC quotas. Thus again, this inability to switch between markets strengthens the ability of Saudi Arabia to keep the markets physically separate.
    Paul Stevens, Oil Market in the Future, The New Energy Pradigm. published by Oxford Uni Press

    So YES! Saudi is setting the Oil Price not the Quantity




    goes without saying, simple point of logic, but evidence always welcome!



  5. Tom Hickey says:

    Saudi Arabia: First Signs of Uprising in World’s Top Oil Exporter

    Interesting factoid: The oil wealth of Saudi Arabia is concentrated almost entirely in the Shia-dominated Eastern Province – that sector of Arabia where popular disaffection is as profound and political alienation as explosive as it is in Bahrain.


    Jim Baird Reply:

    SA is looking like it will be the last and biggest domino to fall. Worst case scenario: the Muslim Brotherhood succeeds in it’s calls for a restoration of the Caliphate, and a “Muslim superstate” across north Africa and the ME that is directly hostile to the West…



    even even more hostile to its own citizens…


    Tom Hickey Reply:

    Look at the demographics. This is a youth revolt in countries with high youth unemployment and cultural repression. Young people everywhere want to get in on the fun and they are being excluded in many places.

    The “new Muslim Caliphate” exists only in imagination. The Muslim world wants a fair shake in the global pie. Economically this is a revolt against neoliberalism and politically against neocolonialism.


    arnabkura Reply:

    Jim Baird,

    I’m from Malaysia where the populations here are consist of Muslim 60.4%, Buddhist 19.2%, Christian 9.1%, Hindu 6.3%, Confucianism, Taoism, other traditional Chinese religions 2.6%, other or unknown 1.5%, none 0.8% (2000 census).
    With main Races are Malay, Chinese and Indian.

    Large Majority of youth and middle income people in our country are against the current govt. The longest ruling party that ever ruled any country not only in the Muslim world but also in the whole world is in Malaysia , the same party has governed our country since 1957. (though there were changes of several Prime Ministers)

    Even our govt have accused us, the opposition (which consist of Muslims, Christian, Buddhist, Hindus, Sikh etc with diverse ethnicity) of wanting to formed the Islamic Caliphate. – That is what they told their western counterparts in Europe and US

    Even one of the most progressive leader in South East Asia, Mr Anwar Ibrahim, has been accused of having a ties with Islamic Terrorism and Being Funded by Saudi’s Money (that is what our ruling elites being telling the U.S and Europeans to justify the crackdown on appositions in Malaysia).

    And to our local people in Malaysia, the ruling party is accusing Mr Anwar of Sodomy and Homosexual (despite that he have a wive and six beautiful children). He is also being accused of having 100% support by the American Administrations (regardless whether its GOP or Demo), The Jews, The Zionist, the World Bankers, The Europeans, the The White, etc to recolonized our country.

    Luckily not many Malaysians believe in their hype anymore, but the admistration got a very powerful tactic up their sleeve – ‘rigged the election’ , but luckily they are not as stupid as Husni Mubarak, despite the rigged – their popular votes were just less than 51%.

    Well even me a secularist, would be accused of conspiring to formed an Islamic Caliphate in South East Asia if I were detained without charge (where it still happen) in Malaysia.

    Cheers and please do not fear the Muslims. we are subjected to economic constraints (even more severe) than you guys.

  6. There is an historical relationship among GDP growth, oil prices and inflation, though perhaps not the relationship many people expect. And because that relationship is unexpected, people may tend to ascribe the wrong causes/effects among those three measures.

    Rodger Malcolm Mitchell


    Art Reply:

    Rodger, aren’t you conflating demand and supply shocks?


  7. Winslow R. says:

    Given the Saudis have been at this for 41+ years, oil revenue should be an ever shrinking portion of their portfolio income.

    If they just invested 10% of their excess oil income each year at 5% real return, their foreign investment income should exceed their oil income by now.

    The Saudis have more freedom each year to manipulate prices to the upside by cutting production without risking political instability at home.


  8. Paul M says:

    History has shown that dictators don’t last for long, usually a generation or two at the most, and the dictator gets too old to effectively control the population and the successor is inept. As a result these uprisings occur especially when the younger generation doesn’t care for the dictator and tey have no jobs or food. So the better question is, who is behind the uprisings and will our interests be welcomed by the succeeding regime.

    Odds are, unless the successors are completely nuts or inept, is that they will realize that world needs their oil and they need our dollars and they need to play ball.

    Hopefully these regimes will get this and we will engage them to help them shape their new regimes in ways that they will be willing to do business with us.

    If not, all hell could break loose in that Israel could feel very isolated and some extremists go off half cocked and do something that would cause this situation to look like a walk in the park.

    Let’s pray for the best!


    Jim Baird Reply:

    Actually, the problem in most of these places is youth unemployment of 40-50%. Too bad these dictators don’t know about MMT, they might last longer…


    Art Reply:

    Jim Baird, rocket scientist. :)


  9. Alex says:

    The solution to this problem is to quite simply ease dependence on oil, and quit whining! Where I live, petrol costs approximately equivalent to USD $1.50 per litre. Given 1 gallon = 3.79 litres, the price of petrol is effectively USD $5.70 per gallon. The difference here is that people don’t commute a ridiculous 39 miles to work like they do in Atlanta. Suburban sprawl will come back to bite!

    The Saudis can do whatever they like to ensure trade is more favorable for them, and rightly so. The USA is making no effort to reduce oil consumption, so it can be guaranteed USA demand will be there for decades. Like any businessman, the Saudis want to get the most out of this.


  10. barton says:

    Warren I understand what you mean when you say you don’t see anything of particular consequence for us in the Mideast uprisings. I imagine you are focussing on what direct economic consequences there might be.

    But taking a broader view, or a view from a different angle, the uprisings do show that a whole nation or a whole society can get absolutely fed up when they are treated poorly over a long period, and take action and demand their rights and to be treated with respect. It is very definitely an awakening, certainly at least a political awakening that is taking place. I’m not saying that we’re going to see mass rioting in the streets of highly developed countries when the people finally get fed up with austerity, severe inequalities and all the crap they have been fed, but just think about it.


  11. Adam says:

    Oil and the economy – my view.

    1. The low prices before 1970 were not sustainable. Yet much of our infrastructure is built on that fact.

    2. This leads to the current situation which is not necessarily high prices as the problem but the volatility of prices that is a problem.


    Tom Hickey Reply:

    US production peaked in 1970. Game-changer.


  12. brian says:

    great commentary, but shouldn’t the saudi’s be forcing higher oil prices in lieu of higher food prices? i consider food and oil to be somewhat interchangeable where we are the prices setter for the former and they are the price setter for the latter. in rising food price environment they need to maintain higher oil prices to stay in power. so i think* oil prices need to go higher but we are still swimming in it from canada hence the wti / brent spread but they are trying to keep it elevated.

    just guesses here



    dueling monopolies?

    also, the price of food contains an energy component, and we burn up corn for fuel, so the causation is probably more from fuel prices to food prices


    Art Reply:


  13. Phil says:

    I would appreciate it if you could go into a little more detail regarding what exactly happened in the 70’s to switch over price setting authority to the Saudi’s. Certainly, inflation went nuts around that time.




    the US always had excess domestic capacity which would have led to what was considered ‘too low’ prices without some sort of quotas, so the Texas Railroad Commission was put in charge of the quotas for the US producers.

    In the early 70’s the Saudis/opec started restricting supply, so that the US no longer had excess supply to regulate, and hence price control shifted to our friendly foreign monopolist.


  14. JKH says:

    interesting parallels


    “That’s like the Fed saying they don’t set $US interest rates, because they have a reaction function that guides them.”

    illustrative of the difference between functional finance and mainstream macro?



    more of a failure to recognize a monopoly.


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